The 2008 Financial Crisis - What Caused It?

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What Caused The 2008 Financial Crisis?

This section of the site relating to bear markets could hardly be complete without a look at the 2008 financial crisis. Though the situation had been building for months (and years) over the course of around six weeks in October 2008, many of the largest financial institutions in the world either came close to collapse, needed some form of rescue or did actually go under. We look at some of the causes here.

There have been a number of books published about the credit crisis and it's causes so far. In their individual ways, each looks at parts of the problem as if it were the whole. Unfortunately, it appears that each may be right in evaluating the problems in an area, but these problems still have to fit in with the all the others. The interconnected, global scale of the problem makes accurate analysis difficult - if not impossible - and also makes workable long-term solutions hard to find.

Everyone on earth must by now of the problems in the United States with homeloans, mortgages and shaky lending standards. For a time, NINJA loans (No Income, No Job or Assets) that carried too much financial incentive to the seller and the re-packager were the problem. However, it appears that these were simply the froth on the top of the beer, the real problems lay way below.

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Despite the risk that each low standard mortgage was adding to the system, it was in the financial interests of the brokers to sell more. As with investment bankers, the long-term health of the financial system was being undermined by a short-term bonus culture in which each individual was acting rationally.

An excellent book on the subject is called Fool's Gold by Gillian Tett. Ms Tett writes the 'Lex' column for the Financial Times and so it can be presumed that she has access to knowledge and people that the rest of us simply do not. She used this access to look into the birth and early years of the derivatives that were to prove so harmful to the world economy. What she found was a team of mathematics geniuses that had found a way - via derivatives - to reduce risks on the balance sheet of a major US investment bank. The careful use and analysis of these products enabled the bank to find other companies, funds and organisations that wanted to take higher risks with their money and were willing to take increased risks to do so.

So far, so much financial common sense.

The problems started to arrive when other banks realised that they could earn millions of dollars in commission for repackaging these risks and selling them on. Before long a business model ballooned as major funds looked to take on low risk (much of this was AAA rated) assets that offered a slightly higher return. Much of this was based around the cash flow of groups of homeloans and mortgages in the USA.

As Tett tells it, there was a tranche of risk - the safest part - of these products that many firms decided was so safe that they would take it themselves. This is called super senior. While it was the safest part, it seems that many firms believed it to be risk free which is actually rather different to lowest risk tranche! Over time, these companies managed to build up tens of billions of dollars (!!!) of super senior on their balance sheets. I think that with hindsight, everyone can now agree that even if an asset is incredibly low risk, if you have tens of billions of dollars worth of it, you are still holding significant risks...

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The unregulated nature of the derivatives market (it seems to be that there were less than 100 people on earth that truly understood these products!) meant that there was no liquid market for super senior. As credit markets started to stick and no bank seemed to be willing to lend to anyone else, it was impossible to value these super senior products. As their values fell, banks looked increasingly sick and prone to immediate bankruptcy.

As we now know, governments viewed some of these mega-banks as being 'too big to fail' and so we 'the people' have stepped in to prop up their balance sheets and somehow keep the world financial system alive - even if only on life support.

There can be little doubt that this borrowing by government is causing another financial shock at some later unknown time. But before that time comes, world stock market's plunged and every major economy on earth fell into recession. Some noteable experts, 2008 Nobel Prize winning economist Paul Krugman among them, suggests that this is the 'mother of all recessions' and possible The Great Depression 2. Not nice.

We recognise that this is a very simplistic overview of the 2008 financial crisis and credit crunch, but it will hopefully lead you to read Fool's Gold by Gillian Tett, which does seem to explain the situation incredibly well.

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